IEUR: Pinching On Financials, Indebted Industrials

The iShares Core MSCI Europe ETF (NYSEARCA:IEUR) covers quality equities in Europe, representing a pretty fair basket of the European economy by sector. The IEUR is diversified with more than 1,000 holdings, so broad level comments on the key sectors of industrials and financials can help us conclude that the valuation of the market in Europe is broadly about fair, especially as pressures begin to show on industry and financials.

IEUR Comments

Let's begin with the sector distribution.

Industrials, financials and healthcare account for about half of the allocations in EUR.

• Industrials - the concern here is that proximity (especially of Germany which drives the industrial exposure) to the effects of the Ukraine war and general dependency in the past on Russian integration creates a substantial delta that puts the European economic situation below the US. Industrials are some of the first to adjust activity and get rational when things start to get a bit difficult. This is evidenced in lower gas demand for European industry, despite a meaningful come-down in price. Cyclical exposures and also indebtedness inherent to industrial assets creates some risk here of meaningful profit crimps.
• Financials - the long story short is that interest rate hikes are now being passed on to savers. We saw in our coverage that European banking had been benefiting from higher NIMs up until now. That is expected to start changing, and it will crimp profits a little.
• Healthcare - this is a decent exposure. Driven recently by Novo Nordisk (NVO) which is actually the largest allocation in IEUR, this exposure is broadly resilient especially as any potentially negative effects from COVID-19 like lower diagnostic rates or declines in diagnostic industry revenue have been lapped.

Beyond these exposures are consumer staples, companies like Nestle (OTCPK:NSRGY) which is a 2.84% allocation overall for the IEUR, which should be pretty resilient and have already demonstrated resilience. Then there's also consumer discretionary, represented by automotive which could be trickier due to the markets being exposed to leverage-based demand - possibly a negative increment once the pent-up demand is exhausted. There is not that much confidence in European automotive at the moment.

Bottom Line

The CPI remains a little high in Europe, and further rate hikes are expected to come with the European rate situation likely to converge further onto the US policy. This is good for the EUR, and may present an interesting FX play for US investors, but at almost a 14x PE, we don't think the valuation is especially compelling for IEUR. The implied earnings yield, while still ahead of benchmark rates, could be higher to demand a margin of safety considering that some major exposures like financials and industrials could start seeing negative increments, potentially pretty hefty ones in industrial if we are to believe that the effects of the rate hikes on the economy are still lagging behind, which is not unreasonable and actually consistent with history. We just want lower multiples in the current high-rate environment for all our stocks.

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